Do Government Programs Grow the Economy?

While decades of increased government spending have resulted in economic stagnation, many advocates of increasing government spending claim that their favored program will “grow the economy.” They argue that if government takes taxpayer money and “invests” it, that is the path to prosperity.

Think of the economy as a small lake. If you fill a bucket on one side of the lake, walk around to the other side (spilling some along the way), and pour the water back into the lake, you aren’t increasing the total amount of water in the lake. But that is exactly how a lot of spending advocates argue government programs will grow our economy.

This argument ignores the basic fact that government has no money of its own, other than that which it takes from taxpayers. Claims that any program “creates” economic growth look only at the seen effect of government spending, not the unseen effect of taking that money out of the economy through higher taxes. How much better would families and businesses spend and invest their own money than politicians?

Economist Greg Mankiw looks at a couple of studies that estimate $1 of government spending will result in $1 to $1.40 in GDP growth. But he then points to evidence that $1 in lower taxes will grow the economy by $3:

By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars.

In a Mercatus brief, Veronica du Rugy and Jakin Debnam ask “Does Government Spending Stimulate Economies?” Their review concludes that economists disagree widely on how much government spending effects the economy, but it appears higher taxes do more harm to the economy:

Some economists find spending multipliers that are smaller than 1.³ Other economists, however, assert that spending multipliers are much larger.⁴ Still others argue that multipliers can’t even be credibly measured.⁵

… Barro and Redlick’s research estimates that the multiplier for changes in defense spending that people think will be temporary – spending for the Iraq war for example – is between 0.4 and 0.5 at the time of the spending and between 0.6 and 0.7 over two years. If the change in defense spending becomes permanent, then these multipliers increase by 0.1 to 0.2.¹¹ Over time, this is a maximum multiplier of 0.9. Thus even in the government’s best-case spending scenario, all of the estimated multipliers are significantly less than one. This means greater government spending crowds out other components of GDP, particularly investment.

In addition, they calculate the impact on the economy if the government funds the spending with taxes. They find that the tax multiplier-the effect on GDP of an increase in taxes-is -1.1. This means that if the government raises taxes by $1, the economy will shrink by $1.1. When this tax multiplier is combined with the effects of the spending multiplier, the overall effect is negative. Barro and Redlick write that, “Since the tax multiplier is larger in magnitude than the spending multipliers, our estimates imply that GDP declines in response to higher defense spending and correspondingly higher tax revenue.”¹² Thus, they conclude that greater government spending financed by tax increases hurts the economy.

Finally, here is a great piece by Matt Mitchell on how economists disagree on the stimulus effects of government spending:

In a 2010 interview, future economic Nobel Laureate Thomas Sargent was asked about the economic advice given to President Obama about that same stimulus bill. He replied: “President Obama should have been told that there are respectable reasons for doubting that fiscal stimulus packages promote prosperity, and that there are serious economic researchers who remain unconvinced.”

Indeed, there is quite a range of professional opinion. Reasonable economists, using valid techniques have found that $1.00 in government purchases can create as much $2 or $3 in new private sector economic activity. But, unfortunately, other, equally-reasonable economists using equally-valid techniques have estimated that $1.00 in government purchases crowd out or destroy as much as $3 or $4 in private sector economic activity.

Pennsylvania faces a four-alarm fire threatening our fiscal house. And the only way to fireproof the Pennsylvania economy is to control government spending, not take more from taxpayers.